BY THOMAS MULHOLLAND
The Walls Street Journal published an interesting article chronicling more of Chesapeake Energy’s financial woes. JP Morgan has also been in the news, having lost $2 billion on so-called hedges. Their actions make them poster children for failed risk management.
We’ve written about Chesapeake’s asset sales previously. They’re selling production and reserves to get cash to fund more drilling. While asset sales bring money in the door now, they also create a long-term liability–the cost to produce gas down the road. Why is Chesapeake doing these deals? Because they’re not generating enough revenue from sales of natural gas to cover the cost of exploration and production–the market price is simply too low, and their business is upside down. One way out is to front-load future cash flows so they can live to fight another day.
But there’s a problem: Asset sales don’t yield enough to pay all the bills. And, if they sell too much now, they’ll create obligations for the future that lay the seeds of another, looming disaster, absent a big jump in natural gas prices.
The WSJ explained that Chesapeake is borrowing heavily–$3 billion in a new, unsecured line of credit. That will help them partially repay a $4 billion secured line of credit. There’s a catch: the interest rate on the new line is 8.5% now and jumps to 11.5% if not repaid by the end of this year; the old line had a rate of 2.75%. The company will pay a higher rate to avoid drawing down all of its existing line and to avoid breaking its terms. Chesapeake’s financing costs will jump by $173 million. The cost of staying solvent just got a lot more expensive; the treadmill is turning faster and faster.
Why is this a risk management issue? Chesapeake is a commodity producer, in an industry rife with risk management techniques and expertise. But even with that backdrop, the company violated a simple but key risk management principle: It didn’t match its book. It buys at a fixed price (leases and field services) and sells at a floating price (natural gas to market). The market is now crushing them for betting the entire company on unhedged speculation. Chesapeake is an example of enterprise-wide risk management failure. [Ironically, investors who agreed to loan Chesapeake $3 billion are also speculating on energy commodities--that gas prices will rise, helping Chesapeake regain financial strength to repay debts.] Bottom line: They could have hedged to maintain adequate cash flows and solvency, but didn’t.
Here’s another example. According to the WSJ, JP Morgan took huge positions in 2011 in derivatives related to corporate bonds to try to protect itself against a possible recession in Europe, which could hurt Morgan by increasing defaults in its nearly $1 trillion loan portfolio. When the economies of Europe strengthened in 2012, Morgan tried to shorten its position, but rather than unwind a part of its bond derivative portfolio, it traded new derivatives–it sold credit default swaps related to bonds maturing in 2017, bought CDS swaps with maturities in 2014, and took a position on the spread between CDS swaps with maturities in 2014 versus 2017. Because JP Morgan didn’t unwind its position in a straightforward way, it took on new, huge, unpredictable, and entirely avoidable risks that the swaps would not move together and deliver expected results.
The market decked Morgan with a one-two punch:
Uppercut: If this was Morgan’s attempt to put on a hedge, it was a poor attempt. If they used financial modeling techniques, and if their analysis predicted the trades would perform well, it reinforces our belief that such approaches are fatally flawed. My own belief is that Morgan’s traders disregarded data showing the trades didn’t correlate well, and put the positions on anyway. That is probably why Morgan showed several executives the door after the trades blew up. Rule No. 1: Thou shalt not violate thine own risk management policy.
Right Cross: They lost $2 billion, and counting, by trying to turn a hedge into a profit engine, which is why it’s not a hedge. Rule No. 2: Thou shalt know the difference between a hedge and a speculation, and handle each accordingly.
JP Morgan learned that risk management can’t serve two masters. Put on a hedge, or take speculative risk, but don’t fool yourself into thinking one set of trades can do both.
Worse yet, Chesapeake didn’t use risk management to protect its most important asset: its existence. It had various transaction-level hedges in place but it did not hedge its giant, overarching, gonna-take-you-to-the-poorhouse risk of buying services at a fixed price and selling gas at a floating price. If it had, it wouldn’t be borrowing billion of dollars just to survive.
Now consider your business. It’s one thing to take risks that are manageable or relatively small in scope, it’s another to take risks that could sink the ship, like Chesapeake and JP Morgan. What trading risks have you identified in your business, and how to you intend to manage them?
